Sunday, March 4, 2012

Manna from Heaven: the Harvard Stimulus Debate

Last week there was a fiscal stimulus debate between titans John Taylor and Larry Summers, at Harvard. Taylor wrote his opening remarks on his blog, which I recommend without further comment. Summers was quoted in the Harvard Crimson:

Summers also said that in studies comparing states that received
varying amounts of stimulus money, those that received more money
experienced higher levels of job growth.

This makes no sense as an argument for overall fiscal stimulus.
The fact is certainly possible. A good example of such studies is by Emi Nakamura and John Steinsson, summarized in their VoxEu blog post. Output rises in states that get more military spending:

...when aggregate military spending in the US rises by 1% of
GDP, military spending in California on average rises by about 3% of
California GDP, while military spending in Illinois rises by only about
0.5% of Illinois GDP. ...we can use
regional variation associated with these buildups to estimate the effect
of a relative increase in spending on relative output. Our conclusion
is that when relative spending in a state increases by 1% of GDP,
relative state GDP rises by 1.5%.

But they're upfront about the limits of this result:

Are multipliers of 1.5 too large to be true? ...
some care is required in interpreting these empirical results. ... in our setting, the region getting the spending
is not paying for it. (My emphasis)

And that's the problem.

Sure. Suppose the government pays contractors to build a military base, or to dig a ditch from Fresno to Bakersfield (high speed rail.) Is anyone surprised that GDP goes up in those areas? The contract itself is a government purchase, and adds to GDP, whether or not the project is of any use at all. When a donut shop relocates from LA, and people spend their salaries on donuts, that counts for more multiplier.

But where did the money come from? Showing that the government can move output around does not show that it can increase output overall. To build the base or rail line, the government had to tax or borrow the money. Cross-sectional studies do not measure the loss of demand in (say) Chicago from the money that got spent in Bakersfield. Actually, the studies can count the loss for stimulus: Every dollar that Chicago's GDP goes down from the extra taxes or borrowing means that the relative output in Bakersfield goes up.

Amazingly, our government has seemed unable to accomplish much of this manna-from-heaven local stimulus in the recent recession. (Steinsson and Nakamura's study was on military expenditure in general, the potential for such "stimulus," not how much of it actually happened in this recession.) John Taylor shows that the actual stimulus didn't even get spent, and when it did, didn't create many jobs. The Wall Street Journal had a nice article a few weeks ago, showing in detail how a $10 billion in stimulus money for wind farms produced few jobs. Even taking administration numbers at face value, we spent hundreds of thousands of dollars for each $50,000/year job "saved."

Larry may be citing studies of the recent recession that disagree. But I think it is a mistake to get too deep in this argument: As a matter of economics, the government should be able to move output around, making one area worse off and another better off. The delicious irony that it was unable to do much of that in this case shouldn't blind us to the fallacy of composition:

Stimulus has to be paid for. In evaluating stimulus for the whole economy, you have to count the loss of demand from the paying-for-it side equally with the raise in demand or employment from the spending-it side.

(If you like to cite New-Keynesian models, beware they are "Ricardian" so you can't even rely on the magic of borrowed money -- you have to defend the idea that taxing Chicago to dig a ditch in Bakersfield raises output on both places by one and a half times the tax. Not impossible (Jon and Emi try), but not as easy as it seems either.)

Summers was also quoted:

“Use your common sense,” Summers said. “Do you really
believe if we had done nothing in response to the crisis in 2008, it
would have been a good idea?”

That's too easy. Medieval doctors said, "the patient is dying, we must do something" before each bleeding.

I know it's unfair to criticize quotations in a college newspaper, so take these as comments on the (very common) ideas rather than anything personal about Summers or exact about the views he presented at the debate. I presume Larry said something a lot deeper.

The debate will be repeated at Stanford, and I hope we get a transcript or a video of this important event. This could be the Scopes Trial or Huxley–Wilberforce debate for fiscal Stimulus.

36 comments:

You're making a Ricardian equivalence assumption in your criticism, but I'm just not sure how strong your assumption is.

I'm yet to get my head around the degree to which Ricardian assumptions drive the multiplier estimation. I'm suspicious that a multiplier estimation under a model with strong Ricardian assumptions ends up with a low multiplier, and a multiplier estimation under a model with weak Ricardian assumptions end up with a high multiplier. I'm suspicious that the most material difference between the various estimates is this assumption.

So the argument is not about the data or the multiplier, it's an empty polticial argument about our prior assumptions.

Then there's an argument that New Keynesian models break down when they try to model debt deflation. I found this article useful:

Use your common sense, if these jokers in government could really direct an economy of 300 million people (who interact with each other and 6.5 billion other people around the world) would the unemployment rate still be >8% after they've spent close to a trillion dollars in stimulus (never mind the trillions of dollars they spend annually in the normal course of trying to control our lives)?

Would you at least have the intellectual honesty to explain to Russell that, while the gov't may not have the ability to manage the economy toward his stated goals, it did have the ability to stop the collapse in 2008/09

This is good - I've made this point about state-level studies on my blog before.

But you're strangely only pointing out the factors that bias these estimates upward (hmmmm...). It's important to point out that there are other reasons to think these estimates are biased upward, particularly the considerable amount of interstate commerce that lets any kind of impact on aggregate demand seep across state lines.

The point remains - they're crumby estimates to use because they're plagued with a huge variety of both negative and positive biases. These could be multiplier overestimates, they could also be underestimates (and you need to be up front about that). It probably depends on the identification strategy in any given study. Generally speaking, though, they're not very reliable.

..."In practice, however, the multiplier for government spending is not very large. The best evidence comes from a recent study by Valerie A. Ramey, an economist at the University of California, San Diego. Based on the United States’ historical record, Professor Ramey estimates that each dollar of government spending increases the G.D.P. by only 1.4 dollars. So, by doing the math, we find that when the G.D.P. expands, less than a third of the increase takes the form of private consumption and investment...A recent study by Christina D. Romer and David H. Romer, then economists at the University of California, Berkeley, finds that a dollar of tax cuts raises the G.D.P. by about $3. According to the Romers, the multiplier for tax cuts is more than twice what Professor Ramey finds for spending increases"...taken from N. Gregory Mankiw's interview for The New York Times @jan 10, 2009

3) Suppose further that a scientist named Johnny Genius is about 10-20 years away from a project that simultaneously cures cancer and makes everyone live forever in perfect health but he needs 1 trillion to finish it and nobody wants to lend it to him ( see #2)

4) government prints a trillion dollars, Johny Genius finishes the project in record time, in 5 years instead of 10-20.

5) resulting prosperity raises real GDP per capita a million times

Did the trillion dollar stimulus need to be paid for ? No.Now, of course I realize we do not live in this kind of a world. But the bottom line is, maybe I am confused, but so far I have not figured out why the assertion that stimulus has to be paid for must be true. The best I can come up with is another assertion: businesses would never pass up huge positive expected value projects so government never needs to step in because if it did it would always crowd out the businesses.

The returns in your hypothetical would be real, and may be worthwhile, but you would still have to pay for it. In the form of inflation and the much higher percentage that debt service would take out of the federal budget.

John, you repetitively argue against fiscal stimulus by citing crowding out effects. But the effect is a lot.weaker when there's a shortfall in AD. Its more convincing if you can show that there is no shortfall in AD.

You also argue that every dollar of the stimulus has to be paid for. But the central bank can fund the entire stimulus by purchasing an equivalent amount of govt bonds.

They get the money by increasing the monetary base. Increased monetary base, through the effect of money multiplier, leads to an increase in money supply. Increased money supply leads to a higher inflation, imposing a tax to entire population. This was an argument made by Tobin and Buiter in the 1980 when they criticized a seminal paper of R. Barro "Are Government Bonds Net Wealth". But, this is just one of the options how the stimulus can be financed.

The second option is an increrase in public debt. If the government tries to finance a stimulus by issuing more debt the crowding-out effect will, eventually, dominate over liquidity effect. In a paper published in Journal of Monetary Economics, by the title "The Optimum Quantity of Debt", Aiyagari and McGrattan estimated that the optimal level of public debt for the U.S economy after World War II is 67% of GDP. On that level of public debt liquidity effect and crowding-out effect cancel each other out. At higher levels of debt crowding out effect dominates. Given the present level of public debt it is clear why the government should not finance a stimulus by issuing more bonds.

I am a little unclear as to how the first option plays out in the scenario though.

So we just print more money and pretend that inflation hits everyone "equally" ? Say what you will about the Austrian school, but I learned the following lesson from them (I think I read it in Hazlitt): just because we can calculate an aggregate inflation doesn't mean that people will face inflation at that level equally.

To say otherwise seems to me be ignoring the premises of stickiness etc that are essential to Keynesian (and especially Krugmanian) thinking.

That being said I think that the first method leads us right back to Cochrane's locality comparison. How do price level impacts vary across these localities? Might we even inadvertently cause deflation in some places? I don't know the answers...I spend all my time on blogs instead of collecting data...

With the inflation argument I just wanted to emphasise that there is no such thing as a free lunch. The fiscal stimulus will be paid through inflation tax. Inflation tax is not a lump-sum tax. On the contrary, it has redistributive effects. In other words, You, Hazlitt, and other Austrians are apsolutely right: people do not face inflation equally. But the impact of inflation does not vary across localities; it varies across the size and composition of households'wealth. Richer households, with capital invested in real estate and fin. instruments, are less vulnerable to adverse effects of inflation. Poorer households, with higher average propensity to consume, are in much higher financial distress.

Also, Prof. Cochrane emphasised: "The region getting the spending is not paying for it". Correct, but incomplete. The argument should be: "PEOPLE, living in the region getting the spending, are not paying for it".

At the end, I think two things are important:

1. There is no such thing as a free lunch;

2. People benefiting from the stimulus are not the ones paying for it.

I'm curious to understand how Prof. Cochrane's Ricardian Equivalence argument holds in a world where other governments buy large quantities US Treasuries. The US Federal govt's budget constraint continues to hold, so the spending must eventually be paid for. However, depending on the form which the financing takes, the fraction that is paid for by US consumers as opposed to foreign governments (and their taxpayers) is not.

Is he assuming that foreign governments buying US Treasuries are as rational as US consumers? or as the US federal government? Does the degree of international risk-sharing that this financing introduces leave the real economy unchanged?

In an age of globalism, Why don't you think that the Ricardian Equivalence is also global? If companies see that nearly all of the major nations are drowning in debt, and some of the minor ones are insolvent, and everywhere they look they see meddling in the markets by feckless politicians, Then might that not be a situation of regime uncertainty that would cause the effects that Ricardo described?

Kyle8: Ricardian Equivalence requires that we can't expect to shift the economic cost of government spending on someone else. In a global perspective, I think global Ric.Eq. makes as much sense as it does as a national level. That doesn't mean that there can't be winners and losers, i.e. people who expect to come out ahead (or get shafted) and act accordingly.

Bernheim and Bagwell have an old paper where they considered the example of family size. They assumed (1) we all care about our kids, and (2) we run deficits today that we'll finance with higher taxes on our kids. With representative agents, we can get a classic Ricardian result; our generation saves enough to buy the new govt. bonds, we leave them to our kids to pay their higher taxes, and govt. spending has no effect. However, they note that families with more kids will pay a bigger share of future taxes than families with fewer or no kids. Deficits therefore represent transfers from the latter to the former group. If those groups behave differently, that could have macroeconomic effects.

Joseph Schumpeter wisely pointed out that this is true if, and only if, one is on a gold standard.

With fiat currency, ask any accountant, it is just double entry book keeping for the banks buying the gov't bonds. They just credit the bank account of the gov't, as a liability, and add an asset in an amount equal to the amount of the bond purchased.

Of course, don't take my word about Schumpter. Watch the Steve Keen video at this link, at about 14:00. It is an easy way to learn intro economics.

“To build the base or rail line, the government had to tax or borrow the money.” Nonsense: the government / central bank machine can perfectly well just print money. And that’s exactly what they’ve done over the last two or three years.

btw, even Taylor doesn't seem to be ruling out the stimulus. From his blog:

Second, I am not objecting to certain features of macroeconomic theory that are sometimes labeled Keynesian, such as that wages and prices are sticky, or that aggregate demand has a role in short run fluctuations, or even that people’s expectations matter, though I would emphasize that expectations have important rational characteristics. For me such complications—which I have been researching for many years—suggest the need for fewer discretionary policy actions and more systematic rule-like ones.

PROF. WREN-LEWIS OPENED IN HIS BLOG A DISCUSSION ABOUT MICROFUNDAMENTATIONS OF MACRO MODELS. I SAID IN A COMMENT THAT EVERY MACRO MODEL IS MICRO FUNDAMENTED BY ITS CONSTRUCTION PROCESS (AND BECAUSE OF THIS I HAD DIFICULTY TO SEE NON-PARAMETRICAL MODELS AS SCIENCE IN THE FIELD OF MACRO) AND ALMOST EVERYONE SEEMED TO DISGREE WITH ME. I DON'T WANT TO TRY TO REESTART THAT DISCUSSION IN HERE, BUT I THINK PERHAPS IT COULD BE USEFUL IN THE DISCUSSION HERE.

YOU SEE, IN THIS DISCUSSION OF RICARDIAN EQUIVALENCE WE ARE OBVIOUSLY SUPPOSING CONSUMER CHOICE BETWEEN PRESENT AND FUTURE CONSUMPTION. WHAT I BELIEVE THAT IS NOT BEING CONSEIDERED IS THAT THIS KIND OF CONSUMPTION EXISTS ONLY WHEN ONE'S BASIC NEEDS HAVE ALREADY BEEN TAKEN CARE OF. I MEAN, FOR THE REALY POOR INTEREST RATE IS NOT AN ISSUE, THE ISSUE IS BEING ABLE TO PAY THE MONTHLY PAYMENT OF WHATEVER HE OR SHE HAS BOUGHT. IF IT FEETS IN HER SALARY SHE "CAN AFFORD IT", IF IT DOES NOT, "SHE CAN'T". THIS IS A MICRO ISSUE I HAVE SEEN IN A STUDY ONCE AND DON'T REMEMBER WHERE, BUT I HAVE NEVER SEEN A MACROMODEL THAT CONSIDERS THIS AND THE WHOLE DISCUSSION ABOUT RICARDIAN EQUIVALENCE PASSES BY THIS ISSUE. THE QUESTION IS UNTILL WHAT POINT. EVERYONE AGREES THAT THE CRISIS MEANT A SHIFT DOWNWARDS IN SOCEITY'S BUDGET CONSTRAINT. DOES THE QUANTITATIVE EASING MEANT A SHIFT IN THE OTHER DIRECTION AS IT WAS MEANT TO? WAS IT DIRECTED TO THE RIGHT PUBLIC? WHO EXACTLY WOULD BE THIS PUBLIC? IS THAT IDEA THAT WRONG. I MEAN THEY WERE DOING THE BEST WITH THE AVAILABLE KNOWLEDGE, MICRO KNOWLEDGE, WASN'T CHRISTIE ROMER THAT SAID THAT THEY SHOT IN ALL DIRECTIONS TRYING TO SOMEHOW HIT THE TARGET?

Okay, if the government can borrow $1 billion at 3%, invest it in an infrastructure project that has an IRR of 7% partly generated through a local multiplier effect (also, IRR>cost of capital due to coordination and credit problems that prevent similar investments by the private sector), and then pays off the debt by taxing the beneficiaries of the project, what is the problem?

Of course, the increase in taxes will not be targeted specifically at the beneficiaries and will therefore reduce the income of people who do not directly benefit from the new railroad or airport or whatever.

But the benefit of the project can still exceed the cost in the national accounts. That is value creation AND output redistribution. The point is that it's not impossible for value creation to co-exist with output redistribution.

This is very simple and all but ultimately the question is: if the government has valuable projects that it can finance with debt, why not pursue them?

In the real world, the use of necessary infrastructure in a Keynesian manner is made more difficult due to the overwhelming level of debt most countries have due mostly to transfer payments, which do nothing for economic growth.

or the previous stimulus posts here. (Click the "stimulus" collection at right.) I'm all for debt finance of projects that have positive present value (important disclaimer) and can't reasonably be done by the private sector (second important disclaimer).

The claim of "stimulus" is that taxing or borrowing a dollar today and spending it generates a dollar and a half of extra output today even if the present value of the project is zero. Digging ditches and filling them up, bridges to nowhere, or just giving the money away all area supposed to be great ideas.

I have never looked at your models, but I doubt that have inputs for intangibles like vision, hope, maintaining skills, etc.

Thus, I pretty much disregard your observations for you never account for what is key to me---the idle mind is the devil's workshop. I don't know how you can assign a cost to that obvious truth. You wrongly assume there is none.

At the end of the day, it seems to me that is comes down to judgment and I don't see any argument that says a rich society with 15 to 20% unemployment is healthier (short or long run) than a society with 3.5/4% unemployment when you recall that we are talking about people.

In simple words, you seem to have missed the fundamental wisdom of the Bible about economics. Were there is no vision, the people perish.

Your models never offer vision. The preserve the status quo and protect the rich and powerful, but they offer no vision.

I am of the frame of mind that the gov't ought to guaranty everyone a job (who is able bodied), even if it means handing out rakes at the park (and cutting the checks for not working). The wages don't have to be (and I wouldn't argue they should be living), but any reasoned observer of human nature has to admit the societal costs of idleness far exceed the costs of borrowing the minimal amounts needed to achieve "full employment" at 2% per annum

Another way of saying the same thing is that suppose there is a zero NPV project in terms of cash flows it generates, but it would employ workers who would otherwise be idle for 1-2 years. If you properly and fully account for the deterioration of the human capital stock, which happens due to prolonged lack of employment, then simply having those people employed and preventing this deterioration could in itself be a positive npv project.

true, but I am making a point beyond. The evil is not just the deterioration in human capital stock, it is deterioration in their personality and the character and personality of our whole society

LAL

you comment is a total distortion of what I wrote and a red herring, at best. It is also a distortion about the USSR, to the favor of Stalin, which sought full employment through slave labor. Guaranteeing anyone who will work a job is so far different from slavery ...

Due to returns to economies of scale, over time there always has to be a positive multiplier effect. IOW, over time, a larger economy is always more efficient than a smaller one. If one assumes an economy consisted of one commodity---wheat---greater demand for wheat will permit economies of scale, found by the ingenuity of mankind, that will ultimately result in more efficient production and transportation of wheat. That, pretty much, is the history of economic growth---the search for larger markets and all that goes along with such.

IOW, your argument just rips something up, out of context

It seems to me this is the compelling case for Keynes, as demonstrated by WWII, where you have economies of scale operating at levels never before witnessed. What means or methods exist for measuring the returns to scale of the US economy, comparing 1939 to 1946---none.

IOW, in a way, but for different reasons than you think, "supply can create its own demand."

You need a longer view of history. Since mankind built the great pyramids, if no before, there have been no barriers to what man can do, except how to finance the project.

I cannot think of any project having a greater NPV than the construction of the pyramids, at the time, but today, they are priceless. In sum, you seem out of your intellectual depth

I was referring precisely to the soviet union as it really existed well after Stalin: it was not everywhere slave labor.

The soviet union I may remind you had a great number of very competent economists and bureaucrats trying to fully employ their nation. But by intervening in the labor market too much (as well as in many others) they in the LONG run brought their nation to ruins.

You seem well intention-ed so I hate to re-break this to you, but you are asking for the exact same thing the soviets tried.

John, that is not the claim. You are erecting a strawman and then trying to take it down.

Are you claiming that the stimulus Obama administration designed and put together was full of what they thought were zero expected value projects?

Repairing roads, aid to states so they don't fire teachers/fire fighters and police and spending on infrastructure and basic research all seem like positive expected value project to me. What people like Krugman seem to argue, unless I am misunderstanding the discussion, is that we don't have nearly enough of this kind of spending, given the state of the economy

"The claim of "stimulus" is that taxing or borrowing a dollar today and spending it generates a dollar and a half of extra output today even if the present value of the project is zero. Digging ditches and filling them up, bridges to nowhere, or just giving the money away all area supposed to be great ideas."

I suspect most will agree that the first sentence is correct; that is what the debate is about.

I suspect most will agree that the second sentence is vitriol posing as reason. Bridges to nowhere and digging/filling ditches are no one's idea of zero NPV projects; these are projects with strongly negative NPVs. If Prof. Cochrane thinks otherwise, I'd be interested to see who is advocating such projects. Bernanke? Evans? Krugman? Summers?

No, its not a strawman. The claim of Keynesian economics is that more spending creates more output. It does not matter if the spending creates anything of value. (It's better, of course, if it does -- output is not the same as welfare. We can be worse off with more output. But the proposition at hand is about output, and I haven't seen any of our Keynesian friends make this distinction.)

This is the great thing about economics. You can't dodge all the implications of your model. If your model says that wasted spending raises output just as much as positive PV spending, then that's what the model says -- and conversely, you can't use that model to defend a view that we only "good" spending raises output. If you think borrowing/taxing and PV=0 spending will not raise output, then you're not a Keynesian.

The point here is not about what was in the ARRA, or what specific people called for in their blogs. We're after the logical question, can the government raise output $1.5 dollars by borrowing/taxing and then spending $1?

However, here's an example for Simon. Brad DeLong: "anything that boosts the government's deficit over the next two years passes the benefit-cost test--anything at all." http://delong.typepad.com/sdj/2009/11/deficit-neutral-stimulus.html

John, I defer to you as I do not presume to understand these models better than you do. But I think the problem is with the definition of wasted spending. Because your intellectual opponents seem to think that spending which keeps people from being totally idle and on the government dole is not wasted almost by definition because otherwise those individuals deteriorate in terms of their human capital.

For me at least, all I want to know is, should we have more ARRA or less ARRA, not which model is right :) so for that purpose it seems like it should matter what was in it

Regarding the stimulus debate, I believe it certainly did have an effect on the economy, as it did save the automotive industry and bailed out some banks, thereby preventing the possibly necessary restructuring of the private sector. But unlike many of those who recognize this as a positive effect, I see it as an unnecessary distortion of market signals:

"By creating a job for one part of the economy you unwillingly deprive the other, perhaps more successful part of the economy of their income. By artificially reallocating resources this way, a fiscal stimulus slows down the creative and innovative processes of the market economy. A fiscal stimulus can only help an economy retain its pre-crisis status quo. It will not help it nor guide it towards establishing a new equilibrium. Any growth it creates will most likely be 'jobless growth' in which the private sector didn't respond properly to the distorted allocation signals."

These are essentially the findings made by Aronld Kling in his great recent paper I fully recommend - available here.

Thanks to a few abusers I am now moderating comments. I welcome thoughtful disagreement. I will block comments with insulting or abusive language. I'm also blocking totally inane comments. Try to make some sense. I am much more likely to allow critical comments if you have the honesty and courage to use your real name.

About Me and This Blog

This is a blog of news, views, and commentary, from a humorous free-market point of view. After one too many rants at the dinner table, my kids called me "the grumpy economist," and hence this blog and its title.
In real life I'm a Senior Fellow of the Hoover Institution at Stanford. I was formerly a professor at the University of Chicago Booth School of Business. I'm also an adjunct scholar of the Cato Institute. I'm not really grumpy by the way!